Inflation over 300 years

By Helen MacFarlane and Paul Mortimer-Lee of the Bank’s Economics Division.

In recent years, there has been a widening acceptance of the view that the primary purpose of monetary policy should be to maintain price stability, and the primary purpose of central banks should be to secure this. But what has been the history of UK over the first 300 years of the Bank’s existence? How has thinking about inflation developed over that period? And how has the workforce of the Old Lady herself withstood the inflationary ravages of time?

POLITICAL RAVISHMENT or The Old Lady of Threadneedle Street in danger! Cartoon by James Gillray, published in 1797

What is inflation? example, basic foodstuffs such as eggs, lamb and bread—so their prices can be compared. Potatoes, which had arrived in Calculating how much prices have risen during the last 300 Britain by 1694 but were not widespread until much later years is a difficult task. Part of the reason for this is that the (price data are available only from 1762), can be thought of bundle of goods and services that was available in 1694 and as a close substitute for such foodstuffs. But it is more the bundle consumed now show some important differences. difficult to find seventeenth-century analogues of other Some elements are, of course, common to both—for elements in today’s Retail (RPI). What can we

156 Inflation over 300 years compare with the price today of a second-hand car—a What goes up can come down second-hand sedan chair? And although we might be able to At a best estimate, prices have risen by a factor of 67 since discover the relation between the ticket prices for a concert the Bank’s foundation in 1694. If the area of the new £50 of Purcell’s music now and in 1694, we cannot compare the note were increased in the same proportion, the result would prices of digital compact disc recordings of his music. be a note some 4 feet by 3 feet, necessitating cash machines the width of double-doors and vans instead of wallets (and To try to overcome these problems, statisticians and giving a rather different meaning to the phrase ‘velocity of economists have spliced together price indices from a circulation’). Looked at another way, if the current size of number of periods. This technique allows—albeit the £50 note were taken to represent the purchasing power imperfectly—the weights of the goods and services included of £50 in 1694, then to reflect its real purchasing power today, it would need to shrink to smaller than a postage ‘Inflation means that your money won’t buy as much stamp. today as it did when you didn’t have any.’ (Anon) Average inflation rates(a) in the price index to evolve over time. But although spliced Per cent indices give some indication of the broad trends in the price 1900 to 1913 1.3 1914 to 1918 15.3 level since 1694, they can never be exact. There is a much 1919 to 1939 -1.2 wider range of goods and services today, reflecting a more 1940 to 1945 4.3 1946 to 1949 2.6 developed structure of production. So food prices comprise 1950 to 1959 4.3 1960 to 1969 3.5 only a fifth of today’s RPI compared with two thirds in 1970 to 1979 12.5 1694, implying that the index is now much less sensitive to 1980 to 1989 7.4 1990 to 1993 5.1 certain shocks, such as the failure of the grain harvest. (a) Geometric averages.

There are similar problems—including difficulties over the Experience of the general trend in prices since the Second availability of comparisons and over changes in quality— World War might suggest that inflation is always with us. when trying to see how wages have evolved over the period. In fact, the history of the last three centuries is not one of an The standard of education in the population as a whole is unbroken rise in prices, but rather of periods in which prices much higher now than in 1694. And the range of skills increased, others when they fell, and little tendency for available in the workforce is very different (there were no sustained rises or falls. Indeed prices have risen more computer programmers in seventeenth-century England). quickly in the last 50 years than in any similar period since Even over shorter periods, comparison is difficult. Would it 1694; the index of prices tripled between 1694 and 1948, be fair to compare the £30,000 paid to Aston Villa for their but has risen almost 20-fold since. Even within the post-war striker Trevor Ford in 1950 (that year’s record transfer) with period, however, the rate of inflation has varied markedly, as the £2.3 million they paid for Dean Saunders in 1992? the table above illustrates.

Chart 1 Retail Price Index

Logarithmic scale 1694=100 10,000

Nationalisation 6,000 of Bank 1946 3,000 Second World War 1939Ð45 Great Peel’s Bank Depression Charter Act 1929Ð32 1,000 1844 First World War 600 Napoleonic wars Crimean War 1914Ð18 1854Ð56 Sterling fixed to gold 300 1717

Sterling finally left Gold Standard 100 1931

0 1694 1725 1750 17751800 1825 18501875 1900 1925 1950 1975

157 Quarterly Bulletin: May 1994

Wages Chart 3 The profile of nominal wages over the last 300 years has Real wages been similar to that for retail prices, as a comparison of Logarithmic scale 1694=100 Charts 1 and 2 shows. It is notable, however, that real wages 1,000 appear to have been considerably more variable in earlier

600 Chart 2 Nominal wages Logarithmic scale 300 1694=100 100,000

40,000 150

10,000 100

3,000 0 1694 1750 1800 1850 1900 1950 1,000 staff were again complaining of hardship, suffering ‘much 300 difficulty in meeting their unavoidable expenses and maintaining social respectability’.(5) 100

0 1694 1750 1800 1850 1900 1950 Bank clerks—and indeed the Bank’s Chief Cashier—were paid £50 a year in 1694. Increasing this in line with the centuries than they have been in this one (Chart 3)—though 400-fold rise in the overall nominal wage index since then precise comparisons are difficult from the available data.(1) would suggest a figure of £20,000 today. In fact graduate It is clear also that nominal wages have risen by much more entrants into the Bank currently start on a salary around 25% than prices. An index showing movements in builders’ less than this. The Chief Cashier has done rather better. wages relative to a basket of consumables,(2) set at 100 for 1694, had fallen to a low of 62 by 1801. This was in the In 1694, the Bank was cleaned by one person, period of the war with France, when the cost of living rose Susan Bennett. The only woman employed by the Bank at sharply (the price of the basket rose over 30% in 1800). But the time, she was paid £10 a year. Today, the Bank employs by 1993, the index had risen to over 600. a staff of 59 ‘housekeepers’, whose annual salary is around 500 times that in 1694. Bank of England staff also appeared to feel the pinch in the Napoleonic era. According to W Marston Acres: ‘the Swings and roundabouts increase in salaries granted by the Directors in 1800 was not commensurate with the rise in the cost of living, and it was The general trend in the price index masks some very large only because of the money earned by extra work that more changes in relative prices. Even over short periods, relative clerks were not in difficulties’.(3) prices can change substantially, reflecting changes in supply and demand conditions. Since January 1987, for example, ‘When I first started working, I used to dream of the day the RPI sub-index for audio-visual equipment has fallen by when I might be earning the salary I’m starving on around 20%, while that for water charges has doubled. Over today.’ (Anon) the same period, coffee prices have fallen by 1%, while soft-drink prices have risen by over 50%.

In 1821, following five years of peace, clerks’ annual Looking at the prices of three essentials, the average price of increments and maximum attainable salaries were reduced; bread in London in 1694 was 5.6d (about 2.3p) per 4lb.(6) In at the time, prices were falling by over 10% a year. In 1854, 1894, the price was just 5.5d, though it had risen to 1s 5d following the imposition of income tax(4) to finance the war (about 7p) at the time of the Napoleonic wars. In the decade against Russia, clerks were moved to request that the Bank from 1974 to 1984, it tripled; and by 1993, it had risen a pay their tax for them. The request was initially refused, but further 60%. The retail price in London of a ton of coal rose clerks were later granted a 10% rise because of the ‘high by around 70% between 1700 and 1830, to 20 shillings. It prices of provisions concurring with the pressure of income was much the same price in 1900, rose to around 30 shillings tax’—prices rose by around 16% in 1854. But by 1865 the in the 1914Ð18 period, dropped back to 20 shillings after the

(1) See, for example, Crafts, N F R, British Economic Growth during the , 1991. (2) Historical data taken from Phelps Brown, E H and Hopkins, S V, ‘Seven centuries of the price of consumables, compared with builders’ wage-rates’, Economica, 1956. (3) Marston Acres, W, The Bank of England from Within, 1931. (4) Income tax was introduced in 1799 at 2 shillings (10p) in the pound. It was abolished in 1816 and reintroduced with Peel’s tax legislation of 1842. (5) Marston Acres, W, op cit. (6) Figures taken from Mitchell, B R, British Historical Statistics, 1988.

158 Inflation over 300 years

First World War, and then rose to over 30 shillings during W S Jevons was one of the first people to develop the the Second. By the end of 1992, it cost £145. The Bank of concept of a price index.(2) His work was stimulated by the England Quarterly Bulletin is one item to have exhibited fall in the value of gold, following the Australian and downward as well as upward price flexibility over recent Californian discoveries of 1849. Jevons argued that it was years: its price rose by a pound a year from £4 in 1981 to £6 crucial to ‘discriminate permanent from temporary in 1983, before being fixed at £7.50 between 1984 and 1993. fluctuations of prices’. He also hypothesised that It was cut to £6.50 this year—a bargain since the price ‘commercial tides’ might be a reflection of the periodic includes the separate Inflation Report. fluctuations in sunspot activity observed by astronomers in the 19th century—but his observations on the importance of The Bank’s old Threadneedle Street building cost distinguishing absolute and relative price changes have £13,153 7s 9d on completion in 1734; the present proved the more robust. Threadneedle Street building cost £5.3 million in 1939.(1) In the post-war period, residential property prices have risen sharply in nominal and real terms, as Chart 4 shows. ‘The rise and influence of central bankers and inflation has moved in tandem with a shift away from reliance on a metallic base for a currency.’ (John Hartwick, A Chart 4 Brief History of Price, 1993) House price index and RPI Logarithmic scale 1956Ð60=100 10,000 The depression of the 1930s saw the main focus of economics switch towards output and employment, and 3,000 away from money and prices; this was epitomised in Keynes’ General Theory with its concept of unemployment House prices (a) (3) 1,000 equilibrium. With the re-emergence of inflation in the 1940s, however, came the Keynesian notion of an RPI 500 ‘inflationary gap’: inflation was seen as the product of an excess of desired demand over productive potential. 200 Productive potential set a ceiling beyond which output could not rise; any excess ex ante demand would simply translate 100 into inflationary pressure. This approach proved inadequate, 0 however, to explain the coexistence of inflation and 1956 60 65 70 75 80 85 90 (a) Source: Nationwide house price index. unemployment.

In 1958, A W Phillips fitted a curve through a scatter diagram of the rate of change of money wages plotted Inflation theories through the ages against the level of unemployment over the period One of the first-documented episodes of inflation occurred 1861Ð1957. The curve suggested an inverse relationship in ancient Rome. Between the middle of the second between the two variables: the lower the level of (4) Moreover, century AD and the end of the third, the price of wheat rose unemployment, the faster the rise in wages. there was a rate of unemployment greater than zero at which 200-fold. The inflation that this reflected was caused by the wage inflation was zero and the level of (frictional) debasement of the metal currency; a succession of unemployment was matched by the number of vacancies. Emperors assumed that their personal credibility would be As M Blaug put it: ‘the old hope of simultaneous sufficient to maintain the value of coins even if they were achievement of stable prices and full employment had reduced in size. Ordinary citizens simply joined in the to give way to the notion of a trade-off between price practice of cutting the edges off the coins. stability and full employment’.(5) The trade-off mentality was born. Following various efforts to maintain the value of the British currency in relation to the price of gold, in 1717 its value ‘The great tragedy of Science—the slaying of a was fixed explicitly by the astronomer Sir Isaac Newton. beautiful hypothesis by an ugly fact.’ [Thomas Henry The equivalence was maintained until 1931, except for brief Huxley (1825Ð95)] periods at around the time of the Napoleonic wars and during and after the First World War. In the period of the Gold Standard, the predominant view of what determined The statistical relationship captured by the Phillips curve the price level was based on the ‘quantity theory’—the idea began to break down in the mid-1960s when inflation that a change in the money supply would eventually cause persisted despite a continuous rise in unemployment—the prices to rise in the same proportion. Phillips curve seemed to be shifting outwards. The main

(1) Figure quoted in The Bank of England 1891Ð1944, Sayers, R S, 1976. (2) In A serious fall in the value of gold, 1863. (3) Keynes, J M, The general theory of employment, interest and money, 1942. (4) Phillips, A W ,‘The relation between unemployment and the rate of change of money wages in the United Kingdom, 1861–1957’, Economica, 1958. (5) Blaug, M, Economic Theory in Retrospect, 1968.

159 Bank of England Quarterly Bulletin: May 1994 theoretical response to this phenomenon was the expectations-augmented Phillips curve; inflation was taken to be a function of unemployment and expected inflation. In M Friedman’s explanation of this theory,(1) there was a ‘natural’ rate of unemployment (determined by institutional factors) at which the Phillips curve was vertical. Any attempt by government to stimulate the economy and reduce unemployment could have an impact only for as long as employees’ inflation expectations remained below actual inflation. Over time, inflation expectations would adjust and unemployment would move back to its natural rate. The theory raised the question of how expectations are formed. In the extreme case, where expectations are assumed to be ‘rational’, it implied that there was no trade-off between inflation and unemployment even in the short run, and that an economy remained permanently on its vertical long-run Phillips curve.

More recent work on inflation has focused on the credibility of the monetary authorities in their pursuit of anti-inflationary policies. Building on the idea that only unexpected inflation can affect growth, because expected inflation will be built into agents’ decision-making processes, Kydland and Prescott developed the concept of The Old NEW Face of Britain—Inflation and Falling Pound ‘time-inconsistency’.(2) According to them, policy surprises Cartoon by Gerald Scarfe, published in 1976 cannot occur systematically, since agents will begin to anticipate the government’s behaviour and build this into pound to depreciate. Some felt in addition that the Bank was their expectations—with the result that growth will be engaged in unsound banking practices that were leading to unchanged but inflation will be higher. The way around this internal instability. is for the authorities to be able somehow to offer a credible commitment not to spring policy surprises. The body of The Bank rejected these criticisms on the grounds that it economic work developing this approach has been widely could not over-issue notes when new issues were based on used to support the case for central bank independence. the discount of sound short-term commercial paper—the so-called Real Bills Doctrine. The argument was, however, What can we blame for inflation? flawed because the Bank issued new notes by purchasing public bonds as well as by discounting commercial bills. In ‘Inflation is like sin: every government denounces it addition, trading problems with Latin America in 1810 and a and every government practises it.’ (Sir Frederick domestic recession in 1811 showed that many of the Leith-Ross, Observer 1957) commercial bills were less ‘sound’ than they had appeared. The Bank also refused to acknowledge the underlying problem: that the heavy public borrowing associated with The years since the Second World War form the longest the war was being monetised. unbroken period of annual price rises since the founding of the Bank. The pattern in previous periods was of alternating In the early nineteenth century, anti-inflationary policy bursts of inflation and deflation, but little tendency towards consisted mainly of trying to ensure that the Bank either sustained price rises or falls. maintained its ability to redeem its promises to pay; interest rates were set at levels consistent with maintaining the link The chief exception to this was at the time of the Napoleonic to gold. A number of ‘near misses’ with this policy, wars around 1800. The wars led to a sharp rise in prices however, convinced Peel in 1844 to introduce the Bank which was only reversed over the course of the following Charter Act, in an attempt to check the alleged inflationary 100 years. In 1797, the war brought a suspension of specie tendencies of the Bank. payments—payments of gold in exchange for bank notes. The Bank was authorised to refuse to exchange because of In the present century, there was high inflation during the the large payments by the United Kingdom to its allies and First World War—prices rose by over 100%—while output heavy government borrowing. Prices rose and gold fell. Despite the large price rise, which exceeded that in the commanded a premium over its quoted mint price. The United States, the United Kingdom was determined to return Bank was accused by Ricardo and other Bullionists of to the gold standard at the pre-war parity, which it did in over-issuing Bank notes, which they felt was prompting the 1925. This meant an enormous deterioration in UK

(1) Friedman, M, ‘The role of monetary policy,’ American Economic Review, 1968. (2) Kydland, F E and Prescott, E C, ‘Rules rather than discretion: the inconsistency of optimal plans’, Journal of Political Economy, 1977.

160 Inflation over 300 years competitiveness, and led to a long period of deflation even of severity. (As noted earlier, there is evidence from the before the onset of the depression in 1929Ð30. The earliest days that in inflationary periods the Bank’s own experience during the Second World War was of a more employees were expected to exercise wage restraint.) moderate increase in prices, of around 30%. The difference Some periods of wider pay and price restraint appear to have was partly because rationing had the effect of containing had a short-term influence on inflation (for example the pay measured price increases. There was also no sharp price restraint of 1972Ð73). But the restraint has often relied on increase once the war had ended, partly because rationing behaviour on the part of employees and firms that was not in continued for several years and partly because the increase their individual interests; in addition, it has often in civilian employment, as the troops were demobilised, led encouraged governments to follow more inflationary to an increased supply of goods and services. macroeconomic policies. Overall, such periods have frequently been followed by periods of ‘catch up’, as prices A number of factors explain why earlier periods of inflation readjusted to macroeconomic fundamentals. were usually temporary and later reversed. One was the source of the inflationary impetus. Higher prices were Chart 5 often the result of temporary disturbances, such as wars or Rates of growth of consumer prices the failure of harvests. Once peace or the harvest was Annual averages restored, the excess demand for goods in terms of money 1885Ð1938 1950Ð93 subsided. The close interlinkages between different Per cent economies because of the use of a gold standard were 10 another factor; an increase in relative prices in one country tended to produce an outflow of gold from that country, 8 implying a monetary contraction which helped to stabilise prices. 6 In addition, the role and behaviour of the public sector were different. The sharp increase in the level of government 4 debt that accompanied a war was often transitory, and succeeded by a substantial fall in spending once the war had ended. After 1814, for example, government spending fell 2 from almost 30% of GDP to around 10%.(1) In earlier episodes too, the link between government borrowing and 0 United United France Germany(a) Italy Japan inflation was partly the result of the fact that too heavy a Kingdom States reliance was placed on monetary financing of the Source: The Economist. government. More recently—and particularly since the (a) Excluding the years 1920Ð23. 1950s—public debt has generally increased in nominal terms (if not as a proportion of money GDP). This has Factors external to the domestic situation have also regularly reflected in part the greater role given to countercyclical been blamed for boosting inflation—not always with sound fiscal policy—whether discretionary or through the foundation. Chart 5 above, however, could be interpreted as operation of automatic stabilisers. Furthermore, for much of suggesting a degree of contagion in inflation between the early part of the post-war period macroeconomic policies countries. The United Kingdom has certainly not been alone were designed to maintain the economy at a very high level of demand. This almost guaranteed that the inflation Chart 6 resulting from a positive output gap would persist, because Narrow money and prices policies were implemented to prevent the emergence of a Logarithmic scale 1919=100 large negative output gap. As a result, the average output 10,000 gap remained above zero for long periods, and the rate of inflation rose.

3,000 Explanations and cures

During the first 300 years of the Bank’s history, a variety of 1,000 factors have been seen as contributing to the inflationary process. Some blamed the inflation of the 1970s on M0 decimalisation in 1971—the smallest coin increased 2.4 300 times in value, and over time prices caught up with the RPI change. A number of solutions have likewise been suggested to cope with inflation or to avoid it. These have 100 varied from conventional monetary restraint (ie increases in 0 interest rates) to price and wage controls of differing degrees 1920 30 40 50 60 70 80 90

(1) See Veverka, J, ‘The growth of government expenditure in the United Kingdom since 1790’, Scottish Journal of Political Economy, 1963.

161 Bank of England Quarterly Bulletin: May 1994 in experiencing much more rapid inflation in the post-war change in relative prices but no change in the overall price period; the same has been seen in other major countries, level, depends on monetary policy. Inflation is a monetary though the US performance has been slightly better than the phenomenon, and is reflected progressively in money’s loss UK’s in both the 1885–1938 and 1950–93 periods. of value in terms of goods and services. Monetary growth in Germany’s inflation performance has been superior to the excess of the growth in real economic activity can occur US’s in the post-war period; but on earnings the story has without causing inflation, provided that the velocity of been a little different, with the United States consistently circulation of money (the ratio of nominal national income exhibiting lower average growth. to the money stock) falls. There have, however, been almost no instances when inflation has not been associated with an Shocks affecting prices can arise from many sources. increase in the money supply (as Chart 6 shows for the years Whether or not they give rise to inflation, rather than a since 1920).

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